Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

April 2013

What’s not to like? Reports coming out in March pointed to an eventual return to ruddy good health for the nation’s economy, and to improved fortunes for its inhabitants. Due to rising values for stocks and other assets, household net worth recovered to $66 trillion at the end of 2012, the highest since late 2007. So far 2013 has seen a further expansion in aggregate wealth as stocks continued their surge, with the Dow Jones Industrial Average enjoying its longest winning streak in years; both the Dow and the broader S&P 500 index reached record highs, the latter on the final trading day of the quarter. Fueled by money moving into stock funds, these popular gauges returned 11.9% and 10.6% respectively (including dividends) during the year’s first three months, in what would typically be a good annual result. It’s not just these asset values that are raising spirits: S&P 500 companies paid a record $282 billion in dividends last year, a figure that is expected to rise to $300 billion in 2013. That’s real pocket change!

Residential property, which accounts for a larger proportion of household assets than financial holdings, saw values move further along the road to recovery as well. Although home prices remained about 30% below their 2006 peak on average, they increased a smart 8.1% year-over-year in January, the biggest jump since the bubble days of 2006. Furthermore, the public’s outlook for future home values has become increasingly positive. In February 48% of survey respondents—a record high—expected house prices to rise over the next year, compared with 41% at the beginning of the year, and 27% in January 2012. Improving sentiment like this bodes well for the economy, as it tends to encourage people to open their wallets more often. One sad bit of news clouded the picture—the number of people staying in New York City homeless shelters also hit a record—but this unfortunate group of fellow citizens doesn’t have much of an impact on the country’s economic health.

The good news (for market participants at least) hasn’t been confined to the U.S. Asian stock markets have recovered their losses after the Lehman Brothers collapse. Japanese stocks in particular have done nicely for several months and have gained over 16% since the beginning of the year. While data on that country’s economy remain mixed, a transition in the governmental and central banking spheres has boosted hopes that new, highly expansionary fiscal and monetary policies will be effective in helping Japan overcome many years of deflation and economic stagnation. In Europe—home to seemingly unending financial crises and political bickering—equities are near five-year highs. In the “developed world” in general, equity markets have gained about 5% year-to-date.

There are spoilsports at every party. The Economist argues that stocks are at new highs due largely to central bank stimulus policies and warns that a new round of excessive risk-taking may result, similar to the behaviors that brought us the recent crisis. Stocks may already be overvalued, it claims. Corporate profits are at post-World War II highs relative to gross domestic product, threatening an eventual reversion to the mean, and equity valuations are 40-50% above their long-term averages. Nevertheless, The Economist hedges by stating that bull market excesses have not yet reached levels seen in the 1980s and 1990s. The Wall Street Journal provides additional detail along these lines: corporate profits now stand at a record 14.2% of national income versus an average of 10.1% since 1929. Wages, which averaged 55.4% of income over the same period, are currently at 48.6%. The implication is that something has to give, and when it does corporate profitability could suffer, pulling the rug out from under market enthusiasts.

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The Economist could be right about risk-taking. The hunger for income in a 0% world has led to a booming market in all sorts of “junk” securities, driving average yields on such obligations down to record lows below 6% in the process. Demand has been so heavy that some issuers have been able to go light on bond “covenants,” the provisions in loan documents designed to protect investors. There has also been a revival in the market for asset-backed securities, the security form that played an important role in the meltdown of 2007-2009. In contrast to the practices that practically ensured the failure of many of the deals arranged during the pre-crisis period, this time around, the originators—Wall Street banks—are taking pains to ensure the assets backing the new securities issues are of reasonable quality.

Nevertheless, after some of the industry’s largest players got into trouble due to errors in so-called “representations and warranties,” which promised that mortgages and other assets that backed securities were properly created, bankers aren’t taking any chances. The fact that dubious, even fraudulent loans were used to create asset-backed securities led to ongoing and expensive litigation for the major financial institutions. Having learned their lesson from these experiences the banks have devised a novel way to prevent similar problems going forward; they simply refuse to accept liability! Security buyers are now being asked to indemnify the banks for errors in future issues.

It also came to our attention recently that banks have returned to the practice of selling financial insurance to protect against events that their so-called “risk models” show to be of extremely low probability, for which they collect fees—another example of return to pre-crisis practices that served bank interests so well, if not the financial system and taxpayers. As with all things when dealing with Wall Street—caveat emptor.

Corporate Interest(s)

Unlike biological persons, corporations can still deduct the interest paid on their debt to arrive at taxable income. But discussions are under way in the U.S. congress to limit that deductibility. It’s about time! The favorable tax treatment of debt financing reduces its cost, distorts corporate finance, and creates an incentive to carry larger debt loads than might be prudent. It also distorts international finance, as foreign companies will issue debt in the U.S. in order to capture the tax benefits.  The use of debt reduces issuers’ overall “cost of capital,” and since capital costs influence the way a business allocates its resources, debt incentives also skew the investment decision-making process by enabling projects that might otherwise be of marginal value. Having to use more expensive debt or equity capital would require financial managers to be more discerning and selective with respect to corporate capital expenditures and would probably lead to fewer of them being undertaken. On the other hand, the increased discipline in the capital spending process should result in better, more productive projects.

Less reliance on “leverage” (debt) would also increase financial flexibility and safety, both for individual companies and for the economy as a whole. Debt can provide a wonderful boost to profitability—during good times. It can also prove a disaster during recessions since the interest and principal payments must still be made at a time when revenues and profits are greatly reduced. Events of the last several years have shown what high levels of debt can do to companies and entire economies; Europe is an especially illustrative example of the latter. Individuals, too, have suffered from excessive debt taken on during the housing bubble (like corporate debt, encouraged by tax subsidies), and from spending resulting from our credit card culture (even without favorable tax treatment).

Despite the obvious benefits of putting equity and debt financing options on an equal footing, such a change seems unlikely to occur soon, as powerful interests have a very large stake in the status quo. Generations of MBA students and corporate financial executives have been indoctrinated in the benefits of “efficient capital structures” (companies financing with some combination of equity and debt). Despite record earnings and high levels of cash, corporations remain as indebted as ever, and any change in the tax status of that debt would be a radical departure from previous practice that would surely meet with fierce resistance from corporate lobbying.

Then there are the industries that owe their very existence to the favorable treatment of debt in the tax code. So-called “private equity” firms (they used to be called “leveraged buyout” firms, for good reason) depend heavily on debt financing for their operations and for the viability of their investments. Lack of interest deductibility would greatly restrict their options.

In our view, less room for maneuver by Wall Street operators is a small price to pay for improved financial stability. Reduced incentives for “financial engineering” might make the financial markets less “entertaining” (and certainly less lucrative for the deal-making crowd), but the healthier markets that would result would be better able to carry out their primary function, which is to allocate capital efficiently. Importantly, the entire financial system would be more resilient and fortified against shocks. There would still be a place for debt, and financial engineers could still “lever up” if they wanted, but they would have to do so without taxpayer support.

 

Dennis Butler, MBA, CFA